Just before Christmas last year, I had the ‘joy’ (forgive my sarcasm) of arriving home to see the gate wide open and my car missing.
It was one of those beautiful sunny days — that time of year before it really starts to heat up — and we’d headed down to the beach to enjoy the last part of a Sunday afternoon.
In the 90 minutes or so that we were away, the thieves had gone through the house taking whatever they believed was of value. Being the enterprising chaps that they were, they loaded the loot into my car and used it to get home.
At first, there seemed little chance of my car being recovered. I expected it to become one of those burnt out wrecks you see on the side of the tracks when hurtling along in a train. Yet less than a week later, a police officer rang to say my car had been located.
A lady had noticed an unfamiliar car parked just near her house. After it had sat idle for a number of days, she’d called the police. A quick check of the registration and the car was soon on the back of a tow truck headed for the insurer’s workshop.
After all the checks had been done, and no damage was established, another fellow in a tow truck kindly delivered the car back to my door. Door-to-door service perhaps, but not the kind you’re after.
When I recently received my insurance renewal, I didn’t wince as much as I used to.
It makes sense to insure your house, car or boat. Or most assets for that matter. The potential cost of repair or replacement for your (or another’s) property is too prohibitive to take on that risk yourself. The risk of not having insurance far outweighs the premiums we pay; that’s why we have it.
When it comes to the stock market, you’ll often see options, or, more accurately, put options, described as a form of insurance. That is, a way to protect your shares.
A put option gives the buyer the right to hand over their shares at a fixed price (called the strike price), before the option expires. If the share price falls below the strike price of the option, the option buyer would exercise their right to sell the shares at that (higher) fixed price.
For taking on this obligation, the option writer (seller) receives a premium. Much like any other type of insurance.
Using ‘Put Options’ As Insurance
With most types of insurance, though, like your car or home, the policy is usually for 12 months. At each anniversary, you’ll be invited to renew your policy with the premium adjusted for any change in risk — like a spate of burglaries in your area.
With many insurance companies, you can choose to split the premium into monthly payments. The overall cost will be higher, but the total amount is known in advance.
However, share options work on much shorter timeframes. While you can buy options with expiries that run out to 12 months and beyond, they are illiquid, and it’s hard to get a competitive price. Most of the action happens with options that expire in the next one to three months.
That means, if you buy a put option to protect your shares, you’ll be back in the market paying another lot in premium every few months. Add each of these premiums up over a year or more, and the cost will soon become prohibitive.
Rather than take out this insurance every few months, an investor might look to take out protection via a put option when the share price has had a good run up; or, if they believe the market is due for a correction.
Of course, trying to pick when this might happen is much easier said than done. But trying to take out this insurance when the market is already falling can become expensive. That’s because of the way an option premium is calculated.
The way a share option is calculated is much more fluid than your home insurance. While your home insurer might review your premium annually, a share option is priced for risk whenever the stock market is open.
If the share price is particularly volatile, the option premium will increase to reflect this. The option writer will want to be compensated even more for taking on a higher level of risk. The bigger the swings in the share price, the higher the chance the option could be exercised.
It’s not a static calculation. Whenever the share price moves, so, too, will the option price. And it’s not just the size of the move in the share price; the more rapidly the share price changes, the more expensive the option premium will be, too.
If you believe a share price is headed for a fall and you buy a put option, you need to think about when to exit the option trade, not just about buying the option.
As options have a limited life, each day their value drops to reflect the number of days until it expires. And this is where share options also differ from other types of insurance.
The closer a share option gets to expiry, the more rapidly this time decay takes effect. In other words, this time destruction accelerates. Those that buy options will often look to exit a trade before this time decay takes effect.
Although it’s not a hard and fast rule, an option typically loses two-thirds of its time value in the last half of its life. If an investor bought an option with three months until expiry, and their trade didn’t work out, they might look to exit with around 45 days to go.
It’s always a trade-off. If an investor closes out a put option position early, they lose their protection. But if they hold the put option until it expires, and the shares don’t fall, they will then end up paying a lot in premium.
The trick is to give the option trade a fixed amount of time to work out. Of course, an investor might be happy to pay the premium and protect their shares until the option expires. But if the move that they fear hasn’t eventuated, they should consider closing out the position before time decay eradicates the value of the option.
For The Daily Reckoning